Short sellers crushed like never before as retail army charges in

Short traders in the American stock market are taking a historic pounding as the retail crowd charges into the most-hated names on Wall Street.

The 50 most-shorted companies on the Russell 3000 Index have now surged 33% so far this year, with the Goldman Sachs Group Inc. basket set for its best month since at least 2008.

Whether it’s the Reddit trader army or the inescapable fate of bears in this market, this year’s rally is following one rule: The more hated a firm, the more loved the stock.

The most famous example is Gamestop Corp. whose short interest stands at nearly 100% of its free float in IHS Markit Ltd. data. With a more than 350% surge this year alone, one hedge fund has already endured big losses on its bearish bet against the consumer electronics firm that’s been upended by the retail frenzy.

As individual traders snap up call options en masse, dealers have been forced to buy the underlying shares to hedge their books while hedge funds cover their positions in what’s known as a short squeeze.

Bed Bath & Beyond Inc., which is among the 20 most shorted stocks on the Russell 3000, surged almost 78% this year thanks to retail buying. AMC Entertainment Holdings Inc. is more than 110% higher after it staved off bankruptcy.

“The shorts have been absolutely destroyed,” said Geoff Garbacz, principal at Quantitative Partners, a research firm that monitors shorting trends.

Animal spirits may be running riot from value companies and small caps to volatile names, but the sudden surge in handful of stocks beloved by the message-board cohort is remarkable even by the standards of these risk-on times.

Still, institutional stock pickers are likely to have closed some bearish wagers in recent months, meaning that for investors as a whole the damage has likely been limited, according to Garbacz.

Amid a market rebound that has defied expectations, short sellers lost 48% last year in the worst decline since at least 2005, compared with a 4.6% gain in long-short funds that still retain net exposure to the market, Hedge Fund Research indexes show.

Short interest dropped in 2020 and stood near an eight-year low as a percentage of free float by the end of December, exchange data compiled by Bloomberg shows.

Whether the recent surge in the most-shorted stocks should scare the pros is a matter of debate. In some respects, it does sit awkwardly with quant investors who trade on the basis of long-term research.

Many systematic managers use stock lending fees as a signal for trading shares, since heavily shorted names typically underperform. One explanation is that short sellers know something others don’t, and the more willing they are to pay for their bets, the better their information probably is.

Yet those sentiments may seem quaint in this era of Reddit’s r/WallStreetBets.

Still, across the entire U.S. market, a strategy that bets on the most-shorted quintile of companies and against shares with the lowest short interest returned a modest 1% this month and has lost 24% over the past 15 years, data compiled by Bloomberg show.

That suggests all this activity in favor of the most-hated stocks may prove short-lived and idiosyncratic.

“It’s a nontraditional short squeeze,” said Garbacz at Quantitative Partners, referring to Gamestop’s recent moves. “It’s not being typically driven by people closing out their positions, it’s been forced because all this options activity is occurring.”